Will the New Fed Get Rid of All its Mortgage-Backed Securities? That Seems to be the Plan

The Fed shouldn’t be getting into “allocating credit.”

The new Fed has trouble taking shape. The seven-member Board of Governors, which is at the core of the policy setting FOMC, has four vacant slots. President Trump’s nominee for one of those slots, Marvin Goodfriend, has been hung up in the Senate for months and appears to go nowhere. Two other nominees are currently trying to navigate the confirmation process: Michelle Bowman, a banking regulator from Kansas; and PIMCO executive Richard Clarida for the vice chairman slot.

Chairman Jerome Powell is a lawyer, not an economist. So for balance, the vice chair is going to be a tried-and-true economist. Clarida fits the bill. But when he testified before the Senate Banking Committee on Tuesday, his views seemed to be a mirror image of Powell’s views. And that’s why what Clarida said about mortgage-backed securities on the Fed’s balance sheet is so interesting – even if he doesn’t make it through the Senate confirmation process – because it likely shows the direction of Powell’s thinking as well.

First things first. Like Powell, Clarida said he “absolutely” supports the Fed’s normalization of interest rates and the balance sheet. Like Powell, he said that the normalized balance sheet should be “a lot smaller,” and that Powell’s suggestion of a range of $2.4 trillion to $2.9 trillion, down from its peak-level of $4.5 trillion, “makes sense.”

So in this sense, what he said about mortgage-backed securities on the Fed’s balance sheet is fascinating: The Fed should shed them entirely, down to zero.

Clarida explained that there are “benefits and costs” of QE, and that as more layers of QE were piled on, “the benefits of QE diminished and the costs went up.” And as vice chairman, he’d “have to take a serious look at the costs of QE.”

Then he was asked about “non-Treasury instruments, like mortgage-backed securities,” for QE – that the Fed, when selecting non-Treasury securities, would be getting into something that it shouldn’t, namely “allocating credit.”

“Yes, absolutely,” Clarida replied: “My preference would be for the Fed to end up with a Treasury-only portfolio.”

He then added that, “as a general proposition, my preference would be to have the balance sheet as much as possible in Treasury securities.”

Shedding MBS from the balance sheet entirely and keeping them off could have a big impact. Currently, the Fed holds $1.74 trillion of MBS. That’s about 26% of all residential mortgage-backed securities outstanding. The Fed is the elephant in the MBS room.

Over the years, given the magnitude, the Fed’s MBS purchases and holdings have been a big force in the mortgage market, helping to push down yields of residential MBS, and thereby helping to push down mortgage rates.

That Clarida is thinking about shedding them entirely appears to be unrelated to mortgage rates per se, and all about what types of decisions the Fed should stay out of – and in this case, that the Fed should stay out of “allocating credit,” which would give one type of private-sector bond a competitive advantage over other types that are not being selected.

This was perhaps also a veiled criticism of the ECB’s QE program, which very specifically and publicly is “allocating credit” by buying (in addition to government bonds) corporate bonds, asset-backed securities, and covered bonds. The individual corporate bonds the ECB has acquired can be viewed in its public data base. For a company, having its bonds acquired by the ECB is deemed a stamp of approval and has pushed the yields of those bonds, and thus the cost of borrowing, way down. In other words, the ECB decides on a daily basis that certain types of private-sector credits, such as bonds of specific companies, will get preferential treatment, and others will not.

Clarida seemed to be saying that the Fed shouldn’t get into these decisions of preferential treatment in the private sector, that at first it might be MBS, but then, like the ECB, the Fed might slither into other credits, such as corporate bonds. Hence, stick to Treasuries only. And given that he and Powell are on the same page on just about all other issues brought up, it’s likely that this view is shared as well.

Why did the Fed ever buy MBS in the first place? Seems a sad commentary on America’s economy when the manufacture of sheetrock/plywood boxes (houses) is such a critical industry that the central bank must support it.

To drive down rates because the government went into austerity fiscal austerity mode exactly when it needed to be stimulative. Now the opposite is happening, we are not getting the fiscal house in order at the top of the cycle. The Fed has had a bunch of well deserved criticism, but given the fiscal policy they had to deal with, it is hard to blame them.

It’s hard to blame them? Look out our currency. It’s a federal reserve note. Who is the federal reserve? Are they elected? Have you ever thought that we wouldn’t have the fiscal problems we currently have if a cabal of bankers couldn’t magically conjure up money from nothing?

Actually given the inflation over the past several years the currency is fine. For now.

Hirsute

May 17, 2018 at 12:47 pm

@Lance Manly

Inflation is good for the currency? WOW. I’d like mine steady, thank you very much. Unfortunately, a group of private bankers has been granted a monopoly on money issuance in the land of the “free” and the “brave.”

Petunia

May 17, 2018 at 9:12 am

The fed bought MBS to inject liquidity into the system. The financial crisis was all about determining what was crap and what wasn’t crap and the Wall St. firms could no longer tell, so the trading stopped cold. The fed came in and bought it all.

The lower interest rates were the result of the lack of demand in the real markets.

2014 – 85 richest people as wealthy as poorest half of the world
2016 – Richest 62 people as wealthy as half of world’s population
2017 – World’s eight richest people have same wealth as poorest 50%
When we really think about it, it could just be eight people that will be worried what the fed does or does not.

I think that most of “the poorest 50%” have negative net wealth, i.e. they are in debt. That means that when liabilities are subtracted from assets, the poorest 50% have only a meager total amount of money.

It’s probably more accurate to state that “poor people are going deeper into debt” than to imply that the world’s eight richest people suddenly became enormously richer during a 36 month period.

If that trend continues, then any guy with a dollar in his pocket and nothing else to his name will be richer than “the poorest 50%”, as they may soon have negative net wealth, i.e. more debt than assets.

It’s a neat rhetorical device, but it’s similar to saying that anyone who questions *any* aspect of the theory of global warming is a “climate change denier”, who is thus implied to be just like a “Holocaust denier”. That’s an attempt to demonize opposition rather than a logical rebuttal.

If you overstate your case with overblown rhetoric, you lose credibility with anyone who values logic more than emotion.

It is a concern that the poor are going deeper into debt, but the way the argument was framed doesn’t highlight the poor, but rather the rich.

“I think that most of “the poorest 50%” have negative net wealth, i.e. they are in debt. That means that when liabilities are subtracted from assets, the poorest 50% have only a meager total amount of money.”

This has always been the case. Poor people are poor.

“It’s probably more accurate to state that “poor people are going deeper into debt” than to imply that the world’s eight richest people suddenly became enormously richer during a 36 month period.”

No, it’s not more accurate. The rich are getting much richer. Capital markets have roared while general economies around the world have been relatively stagnant. Most people derive most of their net worth from regular income, not from capital markets. The wealthiest derive most of their net worth from capital assets, not regular income.

Jeff Bezos’ wealth has gone up $50 billion over those 36 months.

That is “enormously richer.”

“It is a concern that the poor are going deeper into debt, but the way the argument was framed doesn’t highlight the poor, but rather the rich.”

It’s a distinction that doesn’t matter. You’re the one employing rhetorical devices, here.

I believe alot of the MBS purchased by the Fed was bad stuff, or perceived by creditors to be bad stuff. Remember at the peak of the crisis, everything real estate looked terrible. The Fed did this to restore faith in American debt to holders all over the world.

The current Fed can hope and wish to only hold Treasuries in the future but I suspect that will not be possible. Remember Bernanke primed future expectations about how the Fed might buy/could buy anything such as stocks corporate bonds, etc??

Well Bernanke is no fool. He knows the big picture and soon enough we will have another QE needed moment.

The US cannot keep deficit spending 1+ trillion. When that reality changes, we will be in a serious recession.

The MBS the Fed holds these days are all guaranteed by Fannie Mae, Freddie Mac, and Ginnie Mae — therefore by the US Government. So the risk of losing money on them is close to nil.

The MBS the Fed bought during the financial crisis were kept in separate accounts on the Fed’s balance sheet (“Maiden Lane” accounts), and you could see them. The Fed has sold those or written them off over the years, and they’ve been gone for quite a while.

the Fed became a government agency, GSE by holding their paper. No rational banker would have accepted that liability without some guarantee. I recall McCain arguing that the Fed did not have taxpayer support, but I think he lost that one, on points.

The stuff it bought during the months of the financial crisis wasn’t all guaranteed by the GSEs. During those months, it bought all kinds of MBS. Those are long gone.

Billy

May 20, 2018 at 3:19 am

The mbs placed on feral reserve balance sheet performed mych better than anticipated, calling into question the need to bail anyone out, Maiden Lane 1, 2, and 3 made billions. None of the mbs paper was toxic, it performed, only because the feral reserve has inserted itself into re market to prevent massive deflation which would, otherwise, occur.

van_down_by_river

May 17, 2018 at 11:12 pm

Fed MBS —> guaranteed by Fannie, Freddy, Ginnie

Fannie, Freddy, Ginnie —> guaranteed by Government

Government —> guaranteed by Fed

Everything is guaranteed, therefore nothing can go wrong (unless of course you want the currency you earn to be worth something).

The Fed only guarantees that there will never be a debt crisis in the US. It doesn’t guarantee that investors won’t lose money. Investors had it very good for eight years, and investors will fondly reminisce about those eight years for a long time.

Wisdom Seeker

May 18, 2018 at 3:15 pm

One extra point: At the time the Fed got into buying MBS, the Fannie/Freddy bonds were explicitly NOT federally guaranteed. The language disclaiming federal responsibility was clearly in the language of the bonds.

The Fed was and is legally required to only monetize* federally guaranteed debt. During the 2008-2009 crisis they broke the law, allegedly in the name of saving the system.

The explicit Fed backstop on Fanny, Freddy and Ginnie Mae bonds is a post-2008 “innovation” which will undoubtedly prove to have been a really bad idea during a future crisis.

*Monetize debt is what the Fed really does, since they “purchase” bonds using credit-money created from nothing. The financial sector chooses different language to mask this.

That Fannie/Freddy bonds were explicitly NOT federally guaranteed has been my understanding also.

It is also my understanding that the bond-holder most bailed out by the Fed’s support of those bonds was the Chinese government, which I have read was holding quite a lot of them as its dollar reserves. As this was one mechanism through which the Chinese government lent Americans the money to buy all their exports so underpriced due to their contemporaneous exchange rate manipulation, which they were able to get away with in particular because Bernanke refused to name China an exchange rate manipulator, this was an avenue through which Bernanke doubly screwed American workers.

It is about time the FED stuck to their business and not to other peoples and companies business. The backdoor support of speculators has only made them richer and the rest poorer.

Perhaps this, new attitude, ties into the fact that Freddy and Fanny will NOW be issuing mortgages with 3% down and no verifications including geographical ones ( like what country you are from or living in). This would end up being another 2008, and when you couple this with the Executive order from the last president to delete the HUD provisions that forbid any bank involved in or paid a fine relating to ‘bad behavior like fraud, it seems the FED is looking out for the US tax payer this time.

It’s the feds job to inject liquidity into the member banks during crises. They will buy beenie babies if that is what it takes to bail out one of their member banks. They have a history of doing just that already. Look at the Long Term Capital Management and savings and loan scandals. They were there behind the scenes helping an ailing member. If they are never accountable for their member’s bad behavior, why would they change a thing?

“Over the years, given the magnitude, the Fed’s MBS purchases and holdings have been a big force in the mortgage market, helping to push down yields of residential MBS, and thereby helping to push down mortgage rates.”

So, prior to the financial crisis the Fed did not hold any MBS? Or am I wrong. But it seems that you are implying mortgage rates will spike if the Fed were to get out of the ‘holding MBS’ market.

Not only should the Fed get rid of its MBS, the government should get out of the mortgage business in total. Fannie, Freddie, Ginnie Mae, FHA/VA, all of it is responsible for moral hazard in the housing loan market. Banks need to go back to manually underwriting housing loans and keeping them on their books until paid in full. Yes, the 30 year fixed rate loan would probably no longer exist in those circumstances, but house prices would return to more reasonable levels as a result.

The US govt has always been in the mortgage business, going back all the way to the Louisiana Purchase. They sold that land on credit to farmers and it’s how they settled the west. Real estate is the biggest industry in America, the govt will always be involved.

I think the choice between MBS and treasury debt is insignificant compared to the decision to intrude on debt markets in the first place. The Fed is picking winners and losers no matter how you slice it. And the winners are……..the winners!

This is a radical departure from Yellen’s appeal for the (Congressional) authority to buy ‘a broader range of assets’ which at the time did imply stocks. What they do in an emergency is anyone’s guess, and nominees say whatever the Reps want to hear, when the markets go into freefall they will bend the rules. The Fed as a quasi government agency doesn’t need seven members. As president would you trust them if they empty their balance sheet, (and roil the mortgage market and even push us into recession) about what they might be willing to do in the next crisis, (would they take on toxic assets, other than government paper) assuming they are really a private bank? Should be the new Fed be less conducive to monetary legerdemain, how will Treasury monetize?

“I believe that banking institutions are more dangerous to our liberties than standing armies. If the American people ever allow private banks to control the issue of their currency, first by inflation, then by deflation, the banks and corporations that will grow up around [the banks] will deprive the people of all property until their children wake-up homeless on the continent their fathers conquered. The issuing power should be taken from the banks and restored to the people, to whom it properly belongs.” ~ Thomas Jefferson, 1809

“It is well enough that people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning.” ~ Henry Ford, 1922

Agrarian? Just because he rightly saw the enterprise of the day to be productive and sustainable, versus the enterprise of financial manipulation and consolidation, doesn’t mean that he was in favor of only a farm based society. That’s a false equivalent, and shows your bias.

He was anti-bank. He was pro people and freedom. Something the finance proponents and the Hamiltonians fail to ever reconcile, with wisdom and dignity of the humanity.

We need but to look around today for proof. Evey US subject owes hundreds of thousands of dollars on the day he is birthed. Born in debt, but that’s OK. That’s what we need. It’s good for us.

For the sake clarity I’d like to know the sources for your information on that. Just as a side note, I don’t trust Snopes or Wikipedia for several good reasons. My sources are “The Debate Over The Recharter Of The Bank Bill (1809)” and “Thomas Jefferson’s Letter Written To John Taylor on May 28, 1816.” As far as the term “deflation”, sometimes certain quotes have been paraphrased to make them more contemporary to modern terminology. That is a given. I’ve seen that done many a time. However, don’t misunderstand me — if what you say is true, and you can provide me proper sources that verify your claim, I am more than willing to accept it. But also, I’ve learned that too many times that just because someone says it is so, does not necessarily make it so.

Correct. But I wonder if Jefferson would have had a problem with the paraphrasing. Anyway, this is *part* what monticello.org says about the misquotation:

The second part of the quotation (“I believe that banking institutions are more dangerous to our liberties than standing armies”) is a slight misquotation of a statement Jefferson made in a letter to John Taylor in 1816. He wrote, “And I sincerely believe with you, that banking establishments are more dangerous than standing armies; & that the principle of spending money to be paid by posterity, under the name of funding, is but swindling futurity on a large scale”

Hirsuite. Did some further checking on my own and also ended up at the website (www.monticello.org) and found the info you mention. Will correct my quote references accordingly listing them as the source. Thanks. Tamara

FWIW, I agree with you that quotes are paraphrased all the time and that, similar to what Smingles said, it’s obvious Jefferson was opposed to central banking. #MeToo

Debt Free

May 17, 2018 at 12:14 pm

All signs are pointing to a top in the housing market. I am hearing ads on the radio for seminars on flipping houses. Post cards are showing up in the mail from real estate agents offering to buy your house. A local credit union is even offering a promotion where you pay 1% of the loan amount to lock in the current interest rate while you search for your “dream” house.

In 2013, they said that the Fed would never be able to stop buying assets (‘QE Infinity”). Then after it stopped, they said that the Fed would never be able raise interest rates. And after it began raising interest rates, the same people said that the Fed would never be able to shed the assets on its balance sheet. After the Fed started shedding the assets on its balance sheet, the same people say that the Fed will never stop buying MBS :-]

As to the ECB if you are a friend of the nasty little Mafosi in charge of it he will buy your bonds even if they are backed by nothing more tangible than rusty bicycle spokes. This will not end well for the EU taxpayers. And most of club-med, in fact, does not pay tax. Something that is not lost on the Germans.